Last week, the U.S. House of Representatives voted to roll back a number of banking rules enacted in 2010 under the Dodd-Frank Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act, known simply as “Dodd-Frank” for short, was passed in response to the housing crash and subsequent financial meltdown in 2007 and 2008. The legislation was arguably the most significant financial regulation adjustment since the reform bills that followed the Great Depression. Dodd-Frank has been hugely controversial since its inception because of the extremely heavy oversight it placed not just on the financial industry, but also due to the far-reaching effects of the federal entities it created, such as the Consumer Financial Protection Bureau (CFPB). Last week’s passage in the House of the “Financial CHOICE Act” could, if the bill also passes in the Senate, roll back many regulatory changes that have not necessarily protected consumers and that have made getting a mortgage far more difficult for the average homeowner.

How Dodd-Frank Affected Real Estate Investors

Individual real estate investors were caught in the crossfire, so to speak, when then-President Obama signed Dodd-Frank into law in 2010. One of the biggest ways in which it affected real estate investors revolved around new regulation of seller financing, which the law categorized (appropriately) as creating mortgage notes. When a property owner seller-finances the sale of their property, they allow the buyer to make payments to them on the property rather than requiring a traditional bank loan. Dodd-Frank placed stricter rules than had previously been in place on how sellers could finance properties that they were selling to owner-occupants and required that companies and individuals who made more than three home loans each year hire a mortgage loan originator (MLO) to complete transactions. Dodd-Frank also affected how private lenders made their loans and changed how a number of investors and real estate instructors who had previously offered students and colleagues valuable “proof of funds” letters for transactions did business.

On the whole, however, Dodd-Frank mainly affected conventional homebuyers who found themselves unable to finance their primary home purchases via traditional 30-year-fixed mortgages because lenders were wary of the regulations and legislation. Many analysts blame the act for the “credit crunch” that has existed since 2008 as lenders backed off lending practices that they felt might open them up to litigation or create another wave of foreclosures in the future, but smaller players were less affected than many had initially feared. By and large, real estate investors adjusted their practices and then continued with business as usual.

What the Dodd-Frank Repeal Could Mean for Your Real Estate Investing Business

If it was largely “business as usual” for investors once the initial furor over Dodd-Frank passed, what happens now that the current administration might succeed in repealing the act? According to House Financial Services Committee Chairman Jeb Hensarling (R-TX), the biggest effect of the CHOICE act will be to strip a great deal of power from the CFPB. The CFPB was originally intended mainly to protect borrowers from unscrupulous lending practices, but it has extended its reach far beyond that and into all aspects of the nation’s credit industry and into other “consumer protections” as well. Not surprisingly, such federal reach (or overreach, as many see it) has not been well-received in many business sectors where entrepreneurs, small-business owners, and investors feel unfairly targeted. “We will replace Dodd-Frank’s growth-strangling regulations…with reforms that expand access to capital,” Hensarling promised last week. He introduced the CHOICE Act to the House and has promoted it as an avenue to increase small businesses’ options for obtaining capital.

Most real estate investors and, indeed, most of the financial industry, have instinctively applauded the notion of a Dodd-Frank repeal because this population generally supports lower levels of federal oversight. President Trump, an astronomically successful real estate investor himself, has said repeatedly that “tight lending practices” and overzealous bank regulation in the wake of the financial meltdown have hindered a true economic recovery in the United States. Opponents to the repeal like Pamela Banks, senior policy counsel for Consumers Union, say that it could cause another financial crisis by “leaving Americans vulnerable to financial fraud and rip-offs” such as poorly-backed mortgage loans that precipitated the housing crash in 2007.

If the CHOICE Act passes the Senate, which is the next step for the bill if it is to become law, it will move to President Trump’s desk for his approval, which he would likely give. In that event, here are three things that could happen that would directly affect your real estate investing business:

More People Might Start Shopping for Homes

In 2016, first-time home buyers accounted for fewer than one-third of all home purchases for the previous year. That is historically low; the long-term average for this number is closer to 40 percent. Homeownership also was nearly the lowest since the federal government began tracking it, with fewer than two-thirds of the population owning rather than renting. If the Dodd-Frank repeal does loosen loan standards, there is likely to be a burst of buying activity as would-be owners try to make purchases before interest rates rise. The Federal Reserve has said it will raise rates a total of three times in 2017.

You’re Going to Start Hearing About Another Housing Crash

Opponents of the repeal say that loosening lending standards will precipitate another housing crash. In 2007, the housing market melted down in large part because homeowners had borrowed far more money than they could afford to pay back over the long-term due to easy access to subprime loans that required little to no money down and that had what housing advocates call “abusive” terms that required large balloon payments a few years into the loan or that allowed interest rates on those loans to rise abruptly and sharply after an introductory period of low interest. Homeowners took on these loans believing, in many cases, that they would be able to refinance their homes on better terms thanks to fast appreciation, but often failed to successfully do so, resulting in tsunami of foreclosures that culminated in the housing crash.

Most experts agree that another housing crash in the near future due to a Dodd-Frank repeal is unlikely because subprime lending is not incentivized as it was prior to the housing crash and lenders are unlikely to repeat those poor decisions without those incentives in place. Furthermore, tight inventory on the lower, starter-home end of the spectrum is likely to keep demand for real estate both for rentals and ownership strong. Finally, a stabilizing economy and improving employment numbers will probably counteract, at least in the short term, any instability that might result from easier access to mortgage loans.

Renting is Still Going to be Big Business

While the repeal of Dodd-Frank will likely send an immediate flurry of buyers into the market, over the long term it is likely that single-family rentals in particular will continue to be big business for real estate investors. With millennials comprising the largest number of would-be first-time buyers, the amount of existing debt that this population will bring to the table when attempting to buy will likely interfere with their ability to actually land a traditional mortgage. Furthermore, thanks in large part to astronomical student-loan debt, millennials as a population are less likely to find homeownership and the mortgage loan that goes with it as appealing as older generations. The nearly 70-percent homeownership numbers that the U.S. posted immediately prior to the housing crash are unlikely to be repeated even if Dodd-Frank is repealed in its entirety (unlikely in itself), and rentals will quite likely continue to be a strong, stable source of income for investors around the country.

Remember, It’s Not a Done Deal

Perhaps most important for real estate investors to remember as Dodd-Frank dominates the headlines is this: at present, not much has actually changed. President Trump signed an executive order on Dodd-Frank back in March of this year basically demanding a “review” of Dodd-Frank in preparation for the rollout of some type of legislation like the Financial CHOICE Act, but so far, little has happened to really change financial regulation. The CHOICE act has a great deal of support, but it is highly partisan in nature, which will make it difficult for the bill to pass the Senate without being adjusted in order to avoid a filibuster. The Senate announced last week that it would begin work on its own version of the CHOICE Act this summer, and it seems likely that the CHOICE Act will not survive a Senate vote unless the repeal is “toned down” fairly significantly.

For now, the best thing that real estate investors can do is keep their cool and monitor the situation. Dodd-Frank was not the end of the industry, as doomsday-sayers predicted when it passed, nor will its repeal (or the lack of a repeal) save or condemn the national housing market. As is always the case, the true strength of our national housing market and the real estate industry lies in the investors who are active in the sector and who work creatively within whatever confines the government and the market set to generate housing opportunities for the public and new opportunities for success for themselves and others in the process.

Recently I meet a new real estate investor at AZREIA (Phoenix Real Estate Investors Club). She shared with me how seller financing literally saved her from a poorly performing duplex in Kingman, AZ. What follows is her narrative – with my comments.

I currently hold a note on a Duplex in Kingman AZ. This note came about as an accidental solution to a really bad problem property. It is a very short term note with 5% interest(VERY LOW INTEREST RATE) and a balloon. The note has been extended once, and there is an option to extend it again.

I originally acquired the property in August 2014. My investor and I paid cash for the duplex. It was in very bad repair and needed a full rehab. We had originally intended to rehab it and rent it out. We had a lot of issues with the property, many problems with contractors, problems within the partnership, and tons of money issues. We couldn’t get it finished, and it was just sitting vacant and getting vandalized. It was a huge headache for me, a source of serious stress, and a huge money pit. I drove back and forth to Kingman many times to deal with the property, contractors, solve problems, etc. My partner and I fought about it all the time for two years. After a year I wanted to sell it and get out, but he did not. It was a good property. We just could not agree on any aspect of the property. We both had completely different rules for our investing and very different ways of doing things. After almost two years of butting heads and losing money I’d had enough and was desperate to find a way out.

We owned one other property together that I also wanted out of. Both were good properties but it was technically the partnership that I wanted out of. He did not want to sell the other property either. With the help of a local note investor in structuring a buyout contract, I acquired the duplex solely as part of my partner’s buyout of my share of the other property.

I immediately put the duplex up for sale. I was a very motivated seller, but I did not want to discount the price very much because it was a very good property in a good location in downtown Kingman. We had already put 15K into the rehab so one side was really close to being rent ready. The other side still needed full rehab, but it could have cash flowed or at least broken even with just the one side rented.

Very quickly my real estate agent found me an investor buyer who wanted to live in the finished side and slowly rehab the other side until she could rent it out. She was willing to pay full asking price but wanted seller financing and was going to refi within a short period of time. She was willing to put down the amount I asked for (about 40%) which took care of my partner’s buyout of the other property and the small private money loan on the duplex for rehab costs. In September I wrote a $37K note for 6 months at 5% with a balloon due in March of 2017. The sale of this property as a seller finance turned this disaster of a property into an easy, stress free cash-flowing asset.

In March, my buyer was not able to refi and cash me out. Rather than foreclose, I extended her loan. I charged her a fee to extend her loan. She could not pay the fee up front so I added it to her monthly payment. The property now cash flows at a net of $435.50 every month and I do nothing except get a deposit into my bank account. (AKA – Mail Box Money)Taking a note on this property not only turned a disastrous and extremely stressful negative cash flow property into a stress-free income-producing asset, but the new owner is happy because she lives there and works on the property. Eventually her renters will pay her more than she needs to cover her payment to me, or she can sell it. The work she has done so far has increased the property value by quite a bit, so if she sells it she can cash me out and still have a profit.

This is an incredible story with a heart warming solution.

The Seller got her price for the property.

The Seller dissolved was able to disolve a negative partnership due to a very hefty 40% down payment.

The Seller turned a negative cash flow into a positive cash flow

The Seller reduced stress in her life. As she put it so well, ” It was a huge headache for me, a source of serious stress, and a huge money pit.”

The Seller no longer has to commute from Phoenix to Kingman to handle landlord issues.

The Buyer is fixing up the house for the seller. In the event of a foreclosure, the Seller is way ahead

The buyer was able to occupy one side of the duplex and rent out the other half which is paying her mortgage and…she still has a profit.

The real estate agent received a full commission and…………..got a quick sale.

The Second of the Twin Dangers

In a previous post, I gave some cautionary advice and questions relative to a borrower signing a personal guaranty. That personal guaranty allows the creditor to pursue any other assets then owned or acquired in the future by the guarantor should the note go into default and a judgment be obtained. These personal guaranties are frequently required in commercial lending environments wherein the main borrower is an entity such as a corporation or an LLC.

The second of the twin dangers is a cognovit promissory note. I realize that not all states recognize and permit cognovit promissory notes. Those states that do only allow them to be used in a business context; however, I have often seen real estate investors who are borrowing money for their business, or for a rehab or flip, willingly sign a cognovit promissory note without fully understanding what can occur.

A properly formatted cognovit promissory note includes the warning language and agreement that the borrower will, in the event of default, allow for the lender to immediately sue and obtain judgment against them. In other words, the lender/creditor can sue on Monday and, with the filing of the lawsuit, file an answer with the court confessing or admitting to judgment requested in the lawsuit. This means that by Tuesday, the lender/creditor can have a court order signed by a judge granting them judgment in the full amount of the unpaid balance with no opportunity for the borrower to challenge, defend or question the allegations that have just been filed by the lender/creditor. It’s an open and shut case; borrower loses!! That cognovit judgment then becomes a very powerful collection tool to be used in conjunction with a personal guaranty to place liens on any other assets owned by the debtor or guarantor.

I have also seen instances wherein bank attachments and garnishes were filed immediately thereafter based upon the filing of the lawsuit and the confession of judgment according to the terms of the cognovit note, which means it is possible for the borrower/guarantor to not even know they have been sued until after their bank account has been frozen or cleaned out. I don’t think I have to describe to you how paralyzing that can be to a borrower who is in default to have all their money taken from them and have no ability then to retain counsel to fight this situation and try to mitigate the damage.

If you think I’m exaggerating, allow me to share with you one instance in which` I watched a lender holding a cognovit note with a personal guaranty craftily lure the borrower into default by promising a refi that he then delayed. At the closing of the refi, the lender insisted on an extra $15,000 in late fees, penalties and accrued interest, leaving the borrower with the choice of paying that extra money at the refi closing or risk having judgment immediately obtained against him for the full amount of the note he thought was going to be refinanced 60 days earlier.

By now I trust you can understand how powerful these tools are in the hands of a lender or debt collector, particularly one who lacks morals and ethics. That’s why many states no longer permit them to be used. In those situations in which they still can be used, you, the borrower, must be informed and prepared when your lender asks for that type of note or instrument to be signed.

In case you’re wondering, when I represent lenders in commercial transactions, I do my best to get strong personal guaranties and cognovit notes signed by the borrowers. After all, I’m doing everything I can to protect and secure my lending client’s position.

I hope this helps you be better informed for the next time you have to make a borrowing decision.

This past Thursday I had the distinct pleasure of spending 4 hours with Stan Harley, the publisher of The Harley Market Letter. He shared some interesting insights in two canary in the mine real estate markets – Los Angeles and Phoenix and further detailed what can be expected for interest rates in the future. What was astonishing to me is just how powerful market cycles are and how they can be used to hedge one’s bets and to be proactive and not just reactive. Many of the seasoned real estate investors understand there are cycles to all business activity, but few understand simple analysis can be utilized to avoid game changing and unexpected shifts in the market place. Mr. Harley believes that even external events really have no bearing on the math.

Most business strategists and real estate professionals failed to identify the key pivotal turns for the housing market in 2006 and 2012. Market timing – as most are well-aware – is an extraordinarily difficult task. The foundation which underlies the basic principles of his analytical methodology is that market behavior can be described (and predicted) through a combination of simple cycles of differing periods. Cycles are the essential factor in determining how long a trend should run and when to expect reversals.

“The knowledge and exploitatin of cycles embodies one of the most powerful analytical tools available for identifying trends and forecasting their reversale.” Stan Harley

CASE-SHILLER HOME PRICE INDEX

The Case-Shiller home price index tracks the value of residential real estate in 20 metropolitan regions across the United States. There are multiple Case-Shiller home price indices: A national home price index, a 20-city composite index, a 10-city composite index, and twenty individual metro area indices. The index is published on the last Tuesday of each month, with a two-month lag. The graph above depicts home price data from 1890 through the present. The lower graph reflects data for the Phoenix, AZ area region through Q3 2016.

Data for the Phoenix region is somewhat limited compared to the national data as well as data for the southern California region. Because the economies of Arizona and Southern California are inextricialby linked – and the cyclical funcitons for both etch-out similar wave forms – a detailed analysis of the Los Angeles region can tell us alot about the market timing functions for the Phoenix area region. A cyclical analysis of the Los Angelia area region, the largest in the United States, is depicted below. Data for Phoenix and the rest of the country are very similiar.

(Editors note: I forwarded slides from the local AZ Real Estate Investors March market presentation(some of which were from the Cromford Report). Mr. Harley was not surprised they matched up.)

COMPOSITES ARE BACK TO THEIR WINTER OF 2007 LEVELS

Editors Comment–The Canary is in the coal mine.

HOME PRICES ARE PEAKING

Since his last review of the Case Shiller index Mr Harvey has revised his cyclical modeling to the numbers shown in the box above. The baseline cycle appears to be 196.8 months or 16.4 years. Notice how this cyclical function defined the June 1990 – Sept 2006 peaks and the March 1996 – February 2012 lows.
The analysis points to a peak for the Los Angeles area – as well as the National Index overall – in the December 2016 time period. Because of the two month lag in the publishing of the data, we won’t know whether home prices have peaked for several more months. He also noted a narrowing in the range of the monthly price bars – a phenomenon that also occurred at the prior cyclical highs. However, based on the updaded data from the AZREIA slides for the period ending February, 2017, the trend is esclating.

At this point Stan Harvey is predicting a minimal drop of 12% in housing prices.

The Harry Dent team is suggesting a drop of 20% in housing prices.

Personally, I have noticed Days on Market are increasing. One of the local reps of a national title company here in Phoenix suggested they have seen a dramatic slowing in pricing for homes in central Phoenix.

Another title company rep noted their March has been VERY slow. A sales rep from a large local lender said their applications for March are way down.

Long term, Mr. Harley is predicting the big one in February, 2023

INTEREST RATES

Mr. Harley made one basic statement on interest rates. They will come down. Period.

HOW DOES THIS IMPACT NOTE BUYERS?

For note buyers keep your powder dry. Only buy notes with a strong equity position behind them. Another words be patient, and buy notes with a loan to value of less than 70%, preferrably less than 65% – all of which is subjective to mitigating factors. If one maintains that cardinal principal, then even with a potential property value drop of 20%, the chances of a payor walking are minimal.

HOW DOES THIS IMPACT NOTE SELLERS?

Make sure you get at a minimum of 10% down, preferrable 15% – 20% down from your buyer. Continue to require at least an 8% interest rate on your note from your buyer–preferrable 10%, but stay in line with the Dodd-Frank Act requirements. There are multiple posts regarding The Dodd-Frank Act on this site.

HOW DOES THIS IMPACT IRA INVESTORS?

It is all positive. Be conservative and positive. If market interest rates drop as forecasted, seller financed notes continue to be a rewarding investment alternative.

PS–It is all about being proactive and NOT reactive. Alot of money can be made in a down cycle–more than in an up cycle.

A revised version of the Financial CHOICE Act is in the works, according to House Financial Services Chairman and bill author Jeb Hensarling, R-Texas. Hensarling announced at the American Bankers Association Government Relations Summit on Wednesday that a revised version of the act would be released “soon,” but gave no further details on how soon.

Hensarling first introduced the Financial CHOICE act last summer, in response to the 2010 Dodd-Frank act. The president’s team has already indicated support of the Financial CHOICE Act, which, among other things, would modify aspects of Dodd-Frank. The CHOICE Act would help to reform the Consumer Financial Protection Bureau, which, according to author and investment banker Chris Whalen, “has been especially harmful to the mortgage industry and has caused the cost of servicing a mortgage to rise several fold since 2008.”

Hensarling is confident that his legislation will win a vote in the House, however, he fears that it will face a tougher road through the Senate. Republican Senate Banking Committee Chairman Mike Crapo, R-Idaho, faces the challenge of getting at least eight Democrats on boards for large portions of the legislation, according to Hensarling.

“Right now, I fear that a number of Democratic senators are intimidated by their base,” Hensarling said.

Hensarling has not given a specific timeline for when he will release the new timeline, although he did state that the presidential administration views bank deregulation efforts as a priority. It is difficult right now, however, to determine when Congress will be able to fit financial regulation into its schedule, as other acts, such as the Affordable Care Act and Senate confirmations currently dominate Congress.

Despite the opposition, Whalen notes that now is the right time for Financial CHOICE to pass. “There are a number of other issues that may catch the attention of the new President next year, but an amended version of the Financial CHOICE Act has the highest probability of success in 2017,” Whalen said. “Needless to say, the financial services industry including banks, insurers and nonbank financial institutions will be very supportive of passage of some form of the Financial CHOICE Act.”

Editors Comment-This revision, if passed will be a real positive for the consumer and the small note buyer/sellers who work in the seller financed area. It will revise the up to 3 limit per 12 month period looking forward or looking back to 24 seller finaced transactions. When changed it will booste the real estate market. Because of the way this act is written, many servicers are pulling out of several states due to potential liabilities.

In January 2017, an estimated 29,000 homeowners received permanent loan modifications from mortgage servicers during the month according to HOPE NOW, a non-profit alliance of mortgage servicers, investors, counselors, and other mortgage market participants. This total includes modifications completed under both proprietary programs and the government’s Home Affordable Modification Program (HAMP). Of the permanent loan modifications performed that month, approximately 20,000 were through proprietary programs while 9,521 were through HAMP. The HAMP program ended officially in December 2016, though servicers will continue to review homeowners who applied before December 31.

Loan modifications increased by 3 percent from December 2016 to January 2017. Total non-foreclosure solutions, such as total loan modifications, short sales, deed in lieu, and workout plans, for January 2017 approximated 102,000, compared to 26,000 foreclosure sales.

Additionally, foreclosure starts and sales saw an increase in those two months. Foreclosure starts jumped from 49,000 in December to 55,000 in January, while foreclosure sales jumped from 20,000 to 26,000 in that same time. HOPE NOW notes that increases in foreclosure starts and sales are typical with their historical data. Although sales and starts are up month-over-month, the year-over-year data saw decreases. Starts are down 4 percent from January 2016, and sales are down 22 percent.

Other non-foreclosure options decreased in January. Short sales dropped from 4,200 in December to 3,700 in January, while the number deed in-lieu stayed at 1,200 in that time. Serious delinquencies are down month-over-month in January, from 1.50 million in December to 1.46 million in January.

“The HOPE NOW Alliance continues to work with homeowners in need and emphasizes on assisting those that are having difficulties with their mortgage,” said HOPE NOW Executive Director Eric Selk. “Our monthly collection of data indicates that the housing market is improving and setting new norms in the post-crisis environment.”

It is not unusual for a note holed to sell their note to get a certain amount of cash. But………….when given a quote by a note buyer many time they are shocked at the huge discount and insulted—maybe even angry that a note broker or buyer would try to “steal” their “good” paying note. Any proficient note buyer / broker will offer alternatives in the form of quoting to buy a piece or just some of the outstanding balance. Have you ever bought a full pizza? Have you ever bought just a few pieces of pizza? They can sell a whole pizza or sell it by the slice or several slices. Same principle. As the note owner you are selling some of the payments vs all the payments. By doing so your discount is less and you still have the back end principle / payments or “tail” reverting back to you when the partial note buyer receives all of their purchased payments. The majority of these note sellers are not aware of or familiar with partials.

Sometimes as a note owner you only need a specific amount of cash. Selling the whole note makes no cents. There are multiple ways to architect a partial sale. You can sell 12, 24, 60,100 or however many of payments to bring you the cash your need. For the next x# of months, those payments would go to the partial note buyer. After the buyer is paid back, the remaining payments would revert back to you.

Selling a partial gives the note seller a great amount of flexibility. Partials are always a great tool to use when the note holder has an immediate cash requirement and only needs a specific amount of money to cover a specific situation or for a specific purpose. A partial minimizes the discount and frees up cash. It is the best of the best. The terms of the note remain the same for the note payor/borrower. The only thing that changes is the payments are directed to the third party servicing company. Additionally there is contractual language giving the partial buyer the right of first refusal to buy additional payments if they so choose.

What about an early payoff?

Many notes do pay off early. The average time a house or note is paid off historically is 7 – 10 years. If it is paid off early, there are contractual agreements / documents from the outset that are managed by the third party note servicing company determining the payoff and or re-conveyance.

What if the note goes into default?

Unfortunately some notes/mortgages do go into default. IT is a realty of the financial world. If in fact that happens, the contractual agreement spells out the options. Either a buy back from the partial buyer or proceed with the foreclosure /eviction process with the goal of taking back the property and resell it for fair market value. Both the original note buyer and the partial buyer benefit. The partial buyer is made whole with the balance going to the original note seller.

Three Real Life Case Studies

Houston, TX 11/30/15 – Single Family house

Gerry owned a note on a single family house in a so-so area of Houston. He needed money for some personal issues and needed help. I offered to buy the full at a larger discount due to the issues noted below. He was not real enthused with the offer, so we agreed to a partial purchase.

Deal Points

Good Points

Gerry negotiated a great terms with a sort-of strong buyer. Meaning the buyer put down a very strong $14,000 on a $60,000 purchase resulting in a great Loan to Value(LTV). The 7% interest rate was OK. It had a relatively short amortization period of 60 months with a great on time pay history. The 3 Buyer’s FICO scores were weak, but they had a good job history.

Marginal Points

Due to the drop in oil, Houston lost 44,000 jobs. The neighborhood had some marginal houses, but in the process of changing for the good. For these two items, if felt uncomfortable with a full purchase.

Bottom Line

We bought a 24 month partial with the option to purchase the balance in 15 months. It was a secure, safe purchase and Gerry received what he needed. Out Investment to Value was a very secure 26% with a safe Loan to Value of 57%. The graph depicts what we purchased(blue) and what the seller kept. Within one year we bought the gold portion all in our IRA.

Fast forward 11/30/16

Gerry called requesting if Capstone would be interested in purchasing the balance of his note. He had a lingering debt situation. After a short due diligence period, we closed within 10 days. Again Gerry was happy and we were happy owning the full note. Three weeks later we sold the full note to one of our Note Investor Forum Meetup attendees for his ROTH IRA.

Summary

The note seller had a situation, we provided him a solution—twice. The Meetup attendee was in his early 70’s. He wanted a higher yielding note with a shorter amortization period. This was his first note purchase. He is excited to buy additional opportunities.

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Salem, OR 12/20/16 – Land Parcel

A note collleague referred his friend Kirt his client, Joyce who owned a 13.17 acre out parcel. This was the remainder of a larger parcel where she sold other acreage for a large apartment complex. Joyce wanted funding to purchase some precious metals and have money for a small down payment on a new house. We presented two options—a full purchase and a 102 month partial. She accepted the partial due to the smaller discount and liked the idea of the remaining balance of $68,023 coming back to her in 102 months.

Deal Points

Good Points

Joyce’s buyer had a very good job as a helicopter pilot earning close to $150,000/yr. The servicing company provided a very stable 36 month payment history. She also had a survey of the land which had all utilities. Most likely in the future the apartment complex would expand—buying out the pilot and our partial.

Marginal Points

Joyce did not negotiate good note terms. Only a 4% interest rate (her realtor said that was fair). In reality for land it should have been at least 10%.

Bottom Line

We bought a 102 month partial with the option to purchase the balance in the future. It was a secure, safe purchase and Joyce received the funds she needed. We had a very strong ITV of 15% . It was a true win-win. Our referral partner received a referral fee and sold some gold to Joyce. Joyce was able to buy her house and the Capstone investor had a very safe and secure partial note investment in her mothers’ IRA.

Partials are a unique method of meeting many needs for note buyers and sellers. They should not be over looked. It is an incredible passive investment vehicle for your ROTH IRA

Emotional equity mitigates the risk in the note buying process. There three types of notes in this business are of three types which come in the form of high equity, partial equity, and no equity notes. Majority of the note buyers contemplate on the more obvious profits, without giving any consideration to the possibility of profits coming from emotional attachment. Emotional Equity. Many times the forgotten and sometime the most important attribute to consider when purchasing a note.

People were used to buying equity covered deals during 2007 so that in the event that the homeowner makes the decision not to pay any longer, they would have the option of foreclosing and recouping their money while making profit at the same time. Nonetheless, with the housing market crash in which most of the home values were wiped out, the disappearance of those equity notes began. Any attempt to purchase them now will result in paying a premium. This is why it is a wise decision to have the positives to every kind of note taken into consideration. It is worthy to note that purchasing equity against no equity deals is the fact of no-equities being cheaper, yet the upside potentials of the two are identical.

Note Buyers, Homeowners, and Emotional Equity

The fact that homeowners have no concept regarding the worth of their houses and that majority of them are not really interested to know since the houses are theirs anyway, which is most important, are the two things that must be put into consideration before purchasing notes. The majority of homeowners have no interest in leaving their houses, considering the fact that these homes are the places they grew up in, and as such, have lots of memories there. Also, these houses have enough space to contain the entire family. Many of these families have lots of kids that cannot just be uprooted and move them to somewhere else, since such thing could be very difficult to cope with. One who is a note buyer must keep certain things in mind such as details of homeowners having the tendency to continue holding on when it comes to certain things, thereby making it imperative for them to keep on holding to their houses. Note buyers have great opportunity here if there a willingness on their part to take the risk and have things worked out with the homeowners since they will always refuse to vacate their homes. This may be the time for investors to exert effort in carving out plans for homeowners to take into consideration. A no equity deal can benefit both parties, for the fact that the investors will receive monthly payments while simultaneously have the latitude of structuring terms that would favor homeowners.

Nonetheless, it is not only nostalgia that sometimes makes it difficult for homeowners to vacate. Expenses play important role as well. For a party of seven, for example, renting an apartment would prove even more expensive and inconvenient for them. Again residing in an apartment might not be a viable option especially in cases where the homeowner has pets. Matters like these motive homeowners to either look for additional work or demand for a higher income so as to retain their homes and avert foreclosure.

It is for these reasons that note buyers should weigh and make analysis of all probabilities. The perfect note does not really exist. Sometimes people miss an opportunity to make profits just because they want to avoid risks. Have a second thought over this! Emotional Equity is a very important ingredient of the note buying process.

Which is the best approach to analyze a note for the amount of the discount; collateral or yield? While both are important, there are three factors to consider when purchasing a note:

LTV (Note balance-to-Value)

ITV (Investment-to-Value)

Yield.

LTV is the ratio of the note balance to the value of the property. For example, a $100,000 property that sells with 5% down and a $95,000 note balance has an LTV of 95%. The higher the LTV, the higher the risk of the note. Why? Because a high LTV at the initiation of a mortgage indicates how much “skin in the game” the mortgagor has put at risk. To put it in perspective, if a property buyer puts only 5% down on the purchase of a property and borrows the remainder, who is taking the bigger risk; the buyer who has only $5,000 at risk, or the note holder who has $95,000 at risk, with collateral of only $100,000?

Let’s take this scenario into the future ten years where the note has been paid down to $83,000. What is the LTV? 83%, right? Now who has the more at risk, the mortgagor or note holder? Since the mortgagor now has $17,000 equity, as opposed to the original $5,000, the probability the mortgagor will just walk away is reduced.

More importantly, since there is ten years of seasoning, the mortgagor has accumulated what is called “emotional equity” or “psychological attachment”; meaning the mortgagor has established roots in the community, in schools and employment. The chances of the mortgager just packing up and leaving are much less.

An offer based on yield will differ from an offer based on ITV.

Which one should you make?

In other words, even though the property buyer put only 5% down, as time went on, he or she accumulated equity, as well as demonstrating to a note buyer that they are a safer risk now than ten years earlier when they had virtually no risk because of the small down payment, no equity and no roots in the community.

Contrast this to a buyer who puts $20,000 or 20% down on a $100,000 house, with an $80,000 note balance. The LTV is now 80%. The buyer has $20,000 invested in the property. Not only do they have “skin in the game”, but should they get into trouble, they will have more of an opportunity to sell the property to get some, if not all of their investment back. Add to this that the note holder’s collateral is higher with an 80% LTV, than a 95% LTV. In other words, the note holder taking less of risk, and the buyer is taking more of the risk.

Why LTV Matters To A Note Investor

For a note investor, the LTV indicates the amount of “skin in the game” a property buyer put at risk at the origination. As time moves on, the LTV reflects the monetary equity the buyer has accumulated, as well as emotional attachment they have in the property.

With this in mind, let’s examine ITV, or investment-to-value. ITV is the amount a note buyer invested in the note divided by the “as is” value of the property.

To minimize the note investor’s risk, ITV is often tied to the credit score, down payment and property value.

Remember, the only real protection a note investor has is the collateral, or value of the property in the event of default. Since we know the collateral can be devalued by market conditions( the 2008 melt down) and/or deterioration of the property, ITV is very important to the amount of the discount a note buyer requires.

In the above case study, let’s assume the house sold for $100,000 with 5% down, and a $95,000 mortgage at 8% for 30 years, with payments of $697.08. Let’s further assume the mortgagor’s credit scores are in the low 600s. Because of the low credit scores and low down payments, a note investor requires a 65% ITV and at least an 11% yield. What will the investor offer?

For a 65% ITV he would pay $65,000 (65% of $100,000).

To receive an 11% yield a note investor would pay $73,197.

Since the offers are quite different, which one will the note buyer favor?

The note buyer will favor the $65,000 offer.

Rule Of Thumb

An investor should make the offer that gives the note investor the acceptable ITV or yield, WHICHEVER IS LOWER.

In conclusion; LTV tells a note buyer how much “skin in the game” the mortgagor has, or how much monetary or emotional attachment they have in the property.

ITV, on the other hand, tells the note investor how much he or she will invest in the note in relation to the value of the property. Yield is determined by the best and safest use of the note buyer’s money.

The amount of the mortgagor has invested, along with the value of the collateral and their credit score, will determine the ITV of the note buyer. Yield is the rate of return a note buyer demands when considering mortgagors’ credit, property value, and mortgagor’s equity and other risks. When applying LTV, ITV and yield to the purchase of a note, all three are important and should be tied to one another. In other words, the down payment, credit score, value of the property, equity in property should be tied to the ITV and yield a note investor demands.

The more risk an investor incurs because of high LTV, the lower must be the ITV, and the yield must be higher. The note buyer will offer the lesser of the ITV vs. yield.

So, which is most important, LTV, ITV or yield?

The answer is that all are important and interrelate to one another.

Yield is determined by the best and safest

use of the note investor’s money. BUT….

YIELD IS NOT REALIZED UNTIL THE NOTE IS PAID OFF.

The above article was reprinted with permission from The Paper Source newsletter—January, 2017 edition. Tom Henderson, the author, has been buying notes and real estate since the 1980s. He is president of H&P Capital Investments, LLC, which buys, sells and trades owner financed notes.